Synthetic and structured assets

Synthetic and Structured Assets
A Practical Guide to Investment and Risk

Erik Banks



Synthetic and Structured Assets


For other titles in the Wiley Finance Series
please see www.wiley.com/finance


Synthetic and Structured Assets
A Practical Guide to Investment and Risk

Erik Banks


Copyright

C

2006

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Library of Congress Cataloging-in-Publication Data

Banks, Erik.
Synthetic and structured assets / Erik Banks.
p. cm. — (Wiley finance series)
Includes bibliographical references and index.
ISBN-13: 978-0-470-01713-5 (cloth : alk. paper)
ISBN-10: 0-470-01713-9 (cloth : alk: paper)
1. Securities. 2. Structured notes (Securities) 3. Derivative securities.
HG4521.B3463 2006
332.63 2—dc22

I. Title.

II. Series.

2005034995

British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
ISBN 13 978-0-470-01713-5 (HB)
ISBN 10 0-470-01713-9 (HB)
Typeset in 10/12pt Times by TechBooks, New Delhi, India
Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire
This book is printed on acid-free paper responsibly manufactured from sustainable forestry
in which at least two trees are planted for each one used for paper production.


Contents
Acknowledgements

ix

About the author

xi

1 Introduction to Synthetic and Structured Assets
1.1 Development of structured and synthetic assets
1.2 Drivers of market activity
1.3 New product design
1.4 Overview of the text

1
2
3
5
7

2 Financial Building Blocks
2.1 Introduction
2.2 Concepts
2.2.1 Risks
2.2.2 Time value of money and interest rates
2.3 Derivative instruments
2.3.1 Derivatives
2.4 Host securities/liabilities
2.4.1 Public notes/shelf registrations
2.4.2 Private placements
2.4.3 Transferable loans
2.5 Issuing/repackaging vehicles
2.5.1 Special purpose entities

2.5.2 Trusts
2.5.3 Investment companies and partnerships
2.6 Financial engineering and product design

9
9
9
9
11
16
16
38
38
38
39
39
40
41
42
43

3 Callable, Puttable, and Stripped Securities
3.1 Introduction
3.2 Development and market drivers
3.3 Product mechanics and applications
3.3.1 Callable bonds
3.3.2 Puttable bonds
3.3.3 Stripped securities

45

45
45
47
47
52
53


vi

Contents

4 Mortgage- and Asset-backed Securities
4.1 Introduction
4.2 Development and market drivers
4.3 Product mechanics and applications
4.3.1 Mortgage-backed securities
4.3.2 Asset-backed securities

59
59
59
62
62
90

5 Structured Notes and Loans
5.1 Introduction
5.2 Development and market drivers
5.3 Product mechanics and applications

5.3.1 General structural issues
5.3.2 Interest-rate-linked notes
5.3.3 Currency-linked notes
5.3.4 Commodity-linked notes and loans
5.3.5 Equity-linked notes
5.3.6 Credit-linked notes

99
99
99
102
102
104
107
109
110
113

6 Collateralized Debt Obligations
6.1 Introduction
6.2 Development and market drivers
6.3 Product mechanics and applications
6.3.1 General structural issues
6.3.2 Cash flow CDOs and market value CDOs
6.3.3 Balance sheet and arbitrage CDOs
6.3.4 Structured and synthetic CDOs

121
121
121

123
124
133
134
135

7 Insurance-linked Securities and Contingent Capital
7.1 Introduction
7.2 Development and market drivers
7.3 Product mechanics and applications
7.3.1 Insurance-linked securities
7.3.2 Contingent capital structures

141
141
141
143
144
153

8 Convertible Bonds and Equity Hybrids
8.1 Introduction
8.2 Development and market drivers
8.3 Product mechanics and applications
8.3.1 Convertible bonds and variations
8.3.2 Bonds with warrants
8.3.3 Buy/write (covered call) securities
8.3.4 Other equity hybrids

163

163
163
165
166
172
173
177

9 Investment Funds
9.1 Introduction
9.2 Development and market drivers

181
181
181


Contents

9.3 Product mechanics and applications
9.3.1 Structure, diversification, and management
9.3.2 Open-end funds
9.3.3 Closed-end funds
9.3.4 Hedge funds
9.3.5 Exchange-traded funds

vii

184
184

186
193
195
200

10 Derivative Replication, Repackaging, and Structuring
10.1 Introduction
10.2 Development and market drivers
10.3 Product mechanics and applications
10.3.1 Synthetic long and short option and swap positions
10.3.2 Multiple swap/option positions
10.3.3 Asset swaps, liability swaps, and callable/puttable asset swap
packages
10.3.4 Credit derivatives and synthetic credit positions

205
205
205
207
207
214

11 Risk, Legal, and Regulatory Issues
11.1 Introduction
11.2 Risk and financial controls
11.2.1 Market, liquidity and credit risk management
11.2.2 Internal financial and operational controls
11.2.3 Internal audit
11.3 Legal controls
11.3.1 ISDA documentation framework

11.4 Regulatory and accounting issues
11.4.1 Regulatory capital
11.4.2 Regulatory review
11.4.3 Accounting treatment under FAS 133 and IAS 39

247
247
247
247
248
249
249
250
255
255
257
257

Selected References

261

Index

263

231
238

Acknowledgements
I would like to thank Samantha Whittaker and all at John Wiley & Sons for their invaluable
assistance on the project from start to finish. The Wiley team performed to its usual high
standards in all respects. Thanks are also due to a number of colleagues and referees from Merrill
Lynch, Morgan Stanley, UBS, and Citicorp, who provided useful comments and feedback on
key sections.
Most special thanks are due to Milena . . . again!
EB



About the Author
Erik Banks is an independent risk consultant and financial author who has been active in the
investment banking sector for 20 years. Erik has held senior risk management positions at
Merrill Lynch, XL Capital, and Citibank in New York, Tokyo, London, and Hong Kong, and
has written 20 books on derivatives, risk, emerging markets, and merchant banking, including
the John Wiley titles The Simple Rules of Risk, Exchange-Traded Derivatives, Alternative Risk
Transfer, and Catastrophic Risk. He lives in Maine with his wife, Milena, and their horses and
dogs.



1
Introduction to Synthetic
and Structured Assets
Financial activities have been a part of the global economic framework for centuries. Lending,
borrowing, speculating, investing, and hedging, for instance, have been employed for years by
a broad range of institutions in order to achieve specific financial goals. Not surprisingly, as
forces of deregulation, technology, and capital mobility have taken firmer root in the landscape

of the late 20th and early 21st centuries, the financial marketplace has evolved, becoming
increasingly useful, efficient, and sophisticated. It is now common for institutions, which
once relied on basic capital-raising and investment instruments, to turn to a range of highly
customized, though eminently practical, assets and liabilities in order to achieve desired goals.
Our aim in this text is to examine many of these customized instruments, demonstrate how they
have developed and evolved, and consider how they function mechanically, and in practice.
Our target sector can be classified in a number of ways. For our purposes, we consider the
markets and products in two broad forms: structured assets and synthetic assets.

r Structured assets. We define the class of structured assets to include instruments that are

r

created, decomposed, or restructured in some fashion in order to redirect or alter underlying
cash flows. This may be accomplished by altering the properties of physical assets, such
as bonds or equities, through the use of special purpose entities/trusts and/or through the
inclusion of one or more derivative contracts, which are off-balance sheet contracts that
derive their value from some underlying reference.
Synthetic assets. We define the class of synthetic assets to include instruments that are created
exclusively out of one or more derivatives. The package of contracts generates cash flows
that correspond with specific end-user requirements.

There are instances when both classes of assets can be used to achieve the same end results.
Consider, for instance, that a pool of secondary mortgages can be combined through a trust or
special purpose entity (SPE) to create a mortgage-backed security (i.e. a structured asset), while
a mortgage swap or total return swap can be created to mimic the flows of the same pool of
mortgage-backed securities (i.e. a synthetic asset). In some instances, it may be advantageous
to create the asset in structured form, while in other situations it may be beneficial to do so
synthetically. These broad classifications serve us well in arranging the discussion and analysis
which follows, by allowing us to consider separately those instruments that can be decomposed

and restructured through a redirection of cash flows, and those that can be created or replicated
using off balance-sheet contracts.
We consider in this introductory chapter key items related to the historical development of
synthetic and structured assets, and key drivers that have fuelled market expansion over the past
years. We then consider general issues related to new product design, and the essential characteristics that are required for success. In order to frame the material properly, we also provide an
outline of the structure of chapters that follow. These topics provide an appropriate macro context for the more detailed market and product material that follows in the remainder of the book.


2

Synthetic and Structured Assets

1.1 DEVELOPMENT OF STRUCTURED
AND SYNTHETIC ASSETS
Although the broad class of synthetic and structured assets has gained increasing attention and
use since the 1990s, aspects of the market date back many decades. Indeed, some of the most
elemental and popular instruments of the financial markets are structured assets dating back
to the 19th century. Consider, for instance, that the convertible bond, which is a package of a
fixed-income security and an investor equity option to convert the bond into the stock of the
issuer, was first launched in the mid-1800s. The first commodity-linked bond, with redemption
tied to the price of cotton (i.e. a bond and an investor cotton option), dates back to the same era.
Mutual funds, which essentially are single shares of stock representing an interest in a broader
portfolio of assets, were developed in the late 1880s and early 1900s and popularized in the
1960s, and have evolved and expanded since that time. Even callable bonds (e.g. a bond and
an issuer call option) and puttable bonds (e.g. a bond and an investor put option), have been in
existence for several decades, and are now mainstays of the marketplace.
Though the synthetic and structured market traces its roots back a minimum of several
decades, it is clear that the greatest amount of financial innovation and growth has occurred
in more recent times. Key factors such as derivative valuation methods, technology, legal
structuring, market liquidity, cross-border capital flows, and financial creativity have led to the

development of increasingly customized and sophisticated assets. By reacting to forces that
simply did not exist during earlier times, intermediaries have been able to expand their ability
to meet the needs of end-users, including issuers and investors.
For instance, prior to the advent of option valuation models (beginning with seminal work
by Black, Scholes, and Merton in the early 1970s), there was little in the way of comprehensive
options dealing; since options are a core constituent of many of the instruments we consider
below, many new products simply could not be structured.
Similarly, the introduction of more powerful (and inexpensive) computing capacity, starting
in the 1990s and accelerating into the new millennium, has led to the creation of increasingly
complex products that require intensive simulation-based pricing routines. Networking and
communications have also promoted the concept of electronic trading platforms and electronic
communication networks, both of which promise to continue the trend towards online OTC
product trading – including trading of structured and synthetic assets.
Clarification of the legal environment has also proven significant in the development of
the sector. Creation and use of standardized legal documentation (e.g. bank loan agreements,
trading confirmations, International Swaps and Derivatives Association (ISDA) Master Agreements) has made it easier for parties to a transaction to agree binding terms and conditions,
and to settle disputes or disagreements efficiently. Legal agreement on the right to net credit
exposures in the event of bankruptcy has made it possible for participants to manage their risks
(and risk capital) more accurately. Legal development of vehicles such as SPEs and trusts,
often in tax-friendly and legally secure jurisdictions, has likewise prompted new product development. Though legal uniformity does not exist in all countries or regions, it is certainly
prevalent in most of the world’s primary financial dealing jurisdictions (e.g. North America,
Europe, Japan).
Market liquidity has also been an important factor in the development of various instruments.
As many financial assets and contracts have developed a core base of interest among an
increasingly broad group of users, liquidity has grown in tandem. This has been especially
important for basic financial assets that are used to construct structured and synthetic contracts.


Introduction to Synthetic and Structured Assets

3

We shall note in Chapter 2 that the fundamental “building blocks” of the sector are all liquid
instruments that benefit from active two-way flows. Without such market liquidity, it would
be difficult to create, in an economically rational way, the products we discuss in this text. It
is worth noting, of course, that the synthetic and structured assets that result from the financial
engineering process do not feature the same degree of market liquidity as the underlying assets.
Most are far less liquid than the building blocks used in the construction process – a fact that
is hardly surprising, since many of the resulting instruments are intended to meet specific
end-user needs.1
The financial creativity of intermediaries has been a catalyst in structured and synthetic asset
development. Intermediaries tend to respond to the requests and demands of end-use clients
(i.e. the market is demand-, rather than supply-, driven). However, the ability of intermediaries
to apply techniques of financial engineering to create entirely new contracts has helped the
market develop successfully. Leading intermediaries can use their knowledge of markets,
client requirements, and valuation techniques to develop useful, customized assets that meet
specific needs. Intermediaries that can couple financial creativity with a significant amount of
risk-taking are well positioned to win client business.

1.2 DRIVERS OF MARKET ACTIVITY
Financial instruments develop and evolve in the marketplace in order to serve a specific function. If that function is performed successfully, the instrument gains a following and succeeds;
evolutionary iterations may then follow, permitting further expansion. If the function is not
performed successfully, the instrument will eventually fade from use. The specific synthetic
and structured assets we discuss in this book include those that have proven successful over
a period of time; the instruments have achieved a critical mass of interest by addressing the
needs of participants properly. In each of our individual product chapters we shall consider a
series of market drivers that have fuelled market development and growth. All, however, trace
their foundation to a core series of goals that intermediaries and end-users attempt to meet. In
this section we consider, in generic form, some of these elemental market drivers.
Institutions are active in the capital markets in order to achieve one or more core goals related

to some aspect of financial management; the synthetic and structured assets we consider in the
book can help achieve any, or all, of these goals.
Broadly speaking, core financial management goals include:

r Funding. An institution that needs to finance its operations in the external capital markets

r

(rather than via internally generated funds) attempts to do so in an optimal fashion. This generally means arranging the lowest cost of funding while maintaining a balanced portfolio of
liabilities across markets and maturities. Synthetic or structured liabilities are used routinely
to both lower funding costs and provide new or incremental investor/market access.
Hedging. An institution with exposures that can impact inputs or outputs typically tries to
protect against potential downside risks in order to minimize the chance of losses. This
is often accomplished through a formal or informal hedging program that makes use of
appropriate hedges. Once again, synthetic and structured contracts can be used to create the
best possible hedge for an exposure.

1
Even within the overall sector, we can observe differences in market liquidity; some assets, such as senior-rated tranches
of collateralized debt obligations or stripped US Treasuries, feature a reasonable degree of market liquidity, while others, such as
privately placed credit-linked notes with embedded exotic options, feature much less liquidity (and effectively must be considered
“hold until maturity” contracts).


4

Synthetic and Structured Assets

r Investing/yield enhancing. An institution (or department within an institution) that exists

r

solely or primarily to invest cash or capital on behalf of internal operations or external
parties again attempts to achieve its investment goals in a rational and cost-effective manner
by optimizing its risk/return profile. Specific synthetic or structured assets are often an
effective mechanism for increasing returns while preserving a desired risk profile.
Speculating. An institution that is responsible for generating asset returns by taking a greater
amount of risk will again seek to achieve its goals by implementing its speculation program
in a manner that is structured appropriately with regard to concentration, volatility, leverage,
and liquidity. Again, many of the synthetic and structured assets we consider in the text
permit establishment of maximum speculative positions, including those that are heavily
leveraged and/or exposed to complex and volatile risks.

Naturally, these core goals exist because of financial market volatility, a characteristic of the
modern financial markets that generates both risk and opportunity. As long as market volatility
remains a feature of the landscape, and there is little to suggest that it will disappear or even
decline, then these goals should remain intact, helping to fuel further innovation and activity.
Each of these goals, which together comprise the essence of corporate financial activity, can
be met through the use of conventional financial assets and contracts. For instance, a company
seeking funding may choose to access the Eurobond or the syndicated loan markets. One that
is attempting to hedge an interest rate exposure may opt for the listed bond futures markets.
Those trying to invest, yield enhance, or speculate can select from a range of cash or derivative
instruments. It is also true, however, that each of these goals can often be met more effectively
by using synthetic and structured instruments. Thus, the company seeking funding may find it
more cost effective to issue a floating-rate note with an attached swap that converts its interest
expense back into a fixed cost, or sell a fixed bond with embedded options to lower its all-in
funding cost. Similarly, the investor seeking to speculate on a particular index may choose to
introduce a leveraged payout in order to increase its risk/return profile.
So, synthetic and structured assets can help achieve core goals in a better way. The act of
repackaging, restructuring, or synthetically replicating asset or liability profiles can lead to the

same funding, hedging, investing, or speculating profiles – at a lower cost or for a higher return,
and almost certainly in a more efficient manner. This brings us back to our earlier statement –
financial instruments survive and thrive when they are useful. The assets we discuss in this
book have become established in the marketplace precisely because they are useful in helping
institutions achieve their fundamental corporate goals.
Certain other forces supplement the items we have noted above, and serve as additional
drivers:

r Regulation and market access. An institution may want to participate in a specific market –
r

r

from an asset or liability perspective – but may be unable to do so as a result of regulatory
restrictions or barriers to entry. When this occurs, synthetic/structured contracts can often
open up the marketplace to relatively free participation.
Asset creation. An institution may seek a very specific asset or liability profile in order
to fulfill risk, funding, or investment mandates. If this is not available in the conventional
financial sector, structured and synthetic instruments can surface as potential alternatives by
allowing the creation of instruments with relevant yield, maturity, currency, return, and/or
risk characteristics.
Liquidity creation. An institution may be impacted by lack of market liquidity in select
assets or liabilities that form part of its activities; this may be a temporary or permanent


Introduction to Synthetic and Structured Assets

5

Market drivers

Funding

Regulatory/
market
access

Hedging

Asset
creation

Liquidity
creation

Investing

Balance
sheet
optimization

Speculating

Pooling/
diversification

Tax
benefits

Figure 1.1 Key market drivers

r
r
r

condition that can prevent a firm from arranging transactions in the most economic manner
possible (i.e. the illiquidity of market is reflected directly in the size of the bid-offer spread).
Structured and synthetic instruments can be used to inject a level of liquidity into the market,
returning an institution to a more cost-efficient position.
Balance sheet optimization. An institution that actively manages its assets and funding and
capital levels may find it beneficial to use assets or liabilities that help optimize its goals;
in some cases, this may involve transferring exposures off balance sheet via synthetic and
structured assets.
Pooling and diversification. An institution that is attempting to create a balanced portfolio
of risk exposures may find it can do so most effectively by using vehicles that can pool and
diversify risks through a single transaction. A variety of synthetic and structured assets can
help accomplish this goal.
Tax benefits. An institution seeking to exploit tax differences between marketplaces legally in
order to reduce friction costs can do so using certain classes of synthetic/structured contracts.

These primary and secondary drivers, summarized in Figure 1.1, have led to progressively
greater expansion and innovation in the financial markets. Although we have framed our
discussion in general terms in this section, we shall revisit the topic throughout the book in
order to reinforce the point that new products are not created simply to demonstrate financial
engineering skills or generate profits – they are developed by intermediaries in order to fulfill
the specific needs of institutions in the best way possible. Profit streams can be sustained when
products meet client demands.

1.3 NEW PRODUCT DESIGN
Financial intermediaries create new types of product in order to address client requirements.

Some new structured/synthetic products are successful, and many others are not; some achieve
widespread volume or carve out a niche, while others simply fade. When a product no longer
attracts meaningful interest and ceases to be traded, it is abandoned. Most new products that


6

Synthetic and Structured Assets

become accepted in the marketplace feature margin compression over time as more intermediaries and end-users join in the process. This profit compression, coupled with the desire to
service client needs, leads intermediaries to create more new instruments.
A new product must feature certain basic characteristics in order to succeed. These characteristics may relate to the product itself, the underlying asset market, or the regulatory/tax
environment – or all three. Market evidence suggests that a new product is more likely to be
successful when participants (or potential participants) recognize the value it can provide and
wish, therefore, to participate; that is, intermediaries do not need to “convince” participants of
the benefits of entering the marketplace. Such demand-pull, rather than supply-push, creates
a healthier and more sustainable equilibrium. In general, greater likelihood of success exists
when:

r The underlying asset is homogenous, storable, and price-volatile, it is in abundant supply
and features good price transparency (e.g. is not subject to manipulation).

r The asset and its price performance are transparent enough to attract the attention of investors,
hedgers, and speculators (e.g. parties that can help promote liquidity).

r The asset market is developed to the point where there is reasonably strong two-way flow,
r

r

r

ensuring a minimum base of liquidity; indeed, the asset should be linked to other cash or
hedging markets in order to build on two-way flows.
Regulatory and tax treatments are equitable, or those featuring differences/discrepancies can
be arbitraged. In fact, regulatory issues have been, and are likely to remain, a significant
influence in the design of new products and aftermarket activity. If the regulatory environment
moves towards a “level playing field” across national boundaries, then the likelihood that
more institutions can participate in a new asset when it is launched increases significantly.2
There is accounting clarity regarding the instrument. The distinction between debt and
equity creates significant tax implications, and must therefore be considered carefully. For
instance, debt-related structures may feature interest tax deductibility, while equity-related
instruments may face double taxation of dividends (e.g. taxation at the issuer and investor
level, unless the issuer is a strict pass-through entity).
Costs are reasonable. Expenses associated with accounting and regulatory requirements,
along with stamp duties, clearing/settlement expenses, arranging costs, and other tradingrelated spreads, cannot overwhelm the economic rationale for structuring or executing a
transaction.3 The low-cost providers may emerge as leaders in a highly competitive financial
market.

New product development is, unfortunately, an expensive and time-consuming process. For
instance, structures that are meant to be listed and traded very widely (rather than as private
placements, for instance) must be vetted rigorously from a legal and regulatory perspective;
this is especially true if the product is intended for purchase by retail investors. In some
instances, this can take several years to accomplish. Intermediaries supporting this type of
2
For instance, the original PRIMES and SCORES structures we consider in Chapter 8 were “derailed” by unfavorable rulings
from the Internal Revenue Service (IRS). The IRS eventually changed its position and allowed the securities to proceed through a
“grandfathered” grantor trust scheme, but no new trusts were ever formed and the product was eventually wound down, to be replaced
by Morgan Stanley’s new synthetic version (without the attendant regulatory complications), Similarly, Lehman’s attempt to create
unbundled stock units comprised of a coupon bond, growth/income certificate (dividend security), and equity appreciation certificate

(call warrant) met with fierce regulatory and tax resistance, and was abandoned before launch. Many other examples exist.
3
For example, Deutsche Bank’s country basket of stocks failed to displace Morgan Stanley’s world equity baskets because the
bank attempted to reduce tracking error by adding too many small stocks, which added considerably to the costs of trading, custody,
and settlement.


Introduction to Synthetic and Structured Assets

7

development must be prepared to invest human and capital resources in order to reap benefits;
in this sense, they operate just as any other corporation might: allocating capital and human
resources to the creation of a profitable venture that may take months or years to develop
and market. But their role does not cease with the introduction of a new product. In many
instances, financial intermediaries must continue to support the asset by providing ongoing
liquidity (market-making) or by assuming a certain amount of credit, market, or liquidity risk.
Thus, even after a product has been launched successfully, its ongoing viability may depend
in large part on continued participation by the community of intermediaries. This means, of
course, that banks, securities firms, and other product creators must be compensated for risks
taken in supporting the product. Unfortunately, profit margins on new products can compress
quickly as a result of competitive pressures, suggesting that a misbalancing of risk/return may
arise.
Participation in new products generally proceeds through evolutionary stages. Activity might
begin on a very modest scale, with a few intermediaries and end-users arranging transactions.
After some level of experience is gained, changes in the core structure might be implemented in
order to resolve problems, reduce costs, or improve efficiencies. Enhancements may then lead
to greater product marketing by intermediaries and a gradual accumulation of critical mass.
If products are truly customizable, end-users may then begin demanding greater flexibility
in risk/return profiles to meet their needs more accurately. The end result for the successful

new product is a strong base of demand, leading to improved liquidity and tighter pricing –
all while addressing specific client needs. Much of what we have noted above applies to the
product development process in any current or immediate period. However, truly innovative
intermediaries plan ahead, attempting to estimate or predict future client requirements in a
new market environment. By doing so, intermediaries can anticipate, rather than react to,
client demand – gaining valuable time over competitors.

1.4 OVERVIEW OF THE TEXT
There are various ways in which a text on financial contracts can be structured: by marketplace,
function, product, risk characteristics, geography, and so forth. Each approach has its own
merits and, in some instances, shortcomings. We have opted, in this text, to follow a product
focus, which allows us to inject uniformity into a discussion that spans multiple asset and
liability classes. Accordingly, for each of the product chapters (i.e. Chapters 3 through 10), we
include a discussion of market development, growth, and drivers, along with product mechanics
and practical applications. Again, though various approaches can be used to separate the broad
class of synthetic and structured products, we have selected the following categorization:

r Chapter 3: callable, puttable, and stripped securities, including corporate and government
bonds with options or stripped coupons.

r Chapter 4: mortgage- and asset-backed securities, including pass-through securities, mortgage bonds, collateralized mortgage obligations, and receivables/loan-backed securities.

r Chapter 5: structured notes and loans, including interest rate, currency rate, equity, commodity, and credit-linked notes, bonds, and loans.
6: collateralized debt obligations, including cash flow, market value, arbitrage,
balance sheet, structured, and synthetic collateralized bond and loan obligations.
Chapter 7: insurance-linked securities and contingent capital, including catastrophe bonds,
noncatastrophe bonds, contingent debt, and contingent equity.

r Chapter
r

8

Synthetic and Structured Assets
Synthetic and structured assets

Callable, puttable,
and stripped
securities

Mortgage- and
asset-backed
securities

Structured notes
and loans

Collateralized
debt
obligations

Insurance-linked
securities and
contingent
capital

Convertible
bonds and equity
hybrids

Investment
funds

Derivative
replication,
repackaging,
structuring

Figure 1.2 Scope of synthetic and structured asset coverage

r Chapter 8: convertible bonds and equity hybrids, including convertible bonds, mandatory
r
r

convertibles, zero coupon convertibles, reverse convertibles, bonds with equity warrants,
and synthetic buy/write packages.
Chapter 9: investment funds, including open- and closed-end mutual funds, hedge funds,
and exchange-traded funds.
Chapter 10: derivative replication, repackaging, and structuring, including synthetic long
and short option and swap positions, multiple option/swap positions, callable/puttable asset
swap packages, and credit derivatives/synthetic credit positions.
Figure 1.2 summarizes the scope of our product coverage.
Two other chapters supplement the product-specific chapters:

r Chapter
r

2: Financial Building Blocks, which considers the essential concepts and tools
needed to construct or decompose synthetic and structured assets, including derivatives,

host securities, and issuance/repackaging vehicles.
Chapter 11: Risk, Legal, and Regulatory Issues, which addresses the risk management,
financial control, accounting, legal, and regulatory frameworks that surround these unique
contracts.

With this background in hand, we are now prepared to begin our discussion of synthetic and
structured assets by examining the basic tools that are used to create unique contracts.


2
Financial Building Blocks
2.1 INTRODUCTION
The creation of synthetic and structured assets depends critically on the existence of various
financial and legal tools. In fact, the financial instruments and contracts we discuss in this
book exist because a set of building blocks is available to structure and reshape cash flows and
risk profiles to meet the needs of end-users and other participants. Before embarking on our
analysis of synthetic and structured assets, it is helpful to review these building blocks. As we
progress through each product chapter, we will demonstrate how these building blocks lie at
the heart of structured and synthetic asset development.
Since actual, expected, and contingent cash flows underpin much of the business of financial
engineering, we begin our discussion with a brief review of the concepts of risk, time value of
money, and interest rates. We then introduce the essential instruments/vehicles of the synthetic
and structured asset world: derivatives, host securities, and issuing/repackaging vehicles.1 We
shall, of course, revisit each of these in greater detail throughout the course of the book.

2.2 CONCEPTS
2.2.1 Risks
Risk, a cornerstone of finance, can be defined and classified in many different ways. In its
most basic form, risk can be defined as the uncertainty regarding a future outcome. From a
financial perspective, we can expand on this basic definition by noting that financial risk is

the uncertainty associated with the future state of a financial market; this uncertainty may lead
to a profit or a loss.2 Financial risk can be decomposed into various other classes in order to
develop meaningful concepts and metrics; common classes include market risk, credit risk,
liquidity risk, and operating risk; each of these can, in turn, be subdivided further, as noted
below.
The existence of financial risks suggests that parties may experience gains or losses as a
result of their exposures. A proper risk management framework allows such gains/losses to be
identified and weighed properly, so that optimal risk/return decisions can be made. In some
instances this will mean assuming more risks, and in other cases it will mean eliminating or
transforming as much risk as possible. There is, of course, no optimal ex ante profile that is
applicable uniformly to every end-user or intermediary; each firm must consider risk issues in
light of its own operations and goals.
1
Since our intent in this chapter is to acquaint the reader with the basic tools of structured products, we have chosen not to embark
on a financial, mathematical, or legal discourse; rather, we illustrate the fundamental elements of each topic. Readers interested in
pursuing in-depth reviews of the mathematical or legal aspects of the topic are urged to consult the works listed in the reference section.
2
Risk is often classified in either speculative or pure form, particularly as related to the insurance sector. A speculative risk is
one that can yield a loss, a gain, or no loss/gain, while a pure risk can only yield a loss or no loss, but no possibility of a gain. From
a financial markets perspective, we deal primarily with speculative risks; indeed, many of the products we consider in the book are
created with risk/return profiles that can generate gains or losses for the parties involved. We shall consider the narrower version of
pure risk in Chapter 7.


10

Synthetic and Structured Assets

Market risk is the risk of loss arising from the adverse movement of markets or market
references. Within the broad class of market risk we may consider various granular definitions,

including:

r Directional risk: the risk of loss arising from an adverse movement in the direction of a
market/reference, such as an equity, bond, index, currency, or commodity.

r Curve risk: the risk of loss arising from an adverse movement in the shape of a yield curve,
such as a steepening, flattening, or inversion of the curve.

r Volatility risk: the risk of loss arising from an adverse upward/downward movement in the
absolute or relative volatility of a market/reference.

r Basis risk: the risk of loss arising from an adverse movement in the differential between two
asset references, or a futures contract and its underlying deliverable.

r Spread risk: the risk of loss arising from an adverse movement in the differential between
r

a risk-free benchmark and its associated risky counterpart, such as a corporate bond quoted
as a spread to a risk-free government bond.
Correlation risk: the risk of loss arising from a change in the correlation between two or
more assets that define a contract or exposure.

Credit risk is the risk of loss arising from the failure of a counterparty to perform on its
contractual obligations. The class of credit risks can be subdivided into various components,
including:

r Default risk: the risk of loss arising from the outright failure of a counterparty to perform

r

on its liabilities and contractual obligations.3 Default risk exposures may be decomposed
into trading risk exposures (from derivative/financing contracts), direct credit exposures
(from unsecured loans), settlement risk exposures (from currency/securities settlements),
and contingent risk exposures (from future commitments and contingencies that may create
credit exposures).
Sovereign risk: the risk of loss arising from the actions of a government authority on
local/nonlocal assets in its financial system, including capital/exchange controls, currency
devaluation, asset expropriation, or debt moratorium/repudiation.

Liquidity risk4 is the risk of loss arising from an inability to obtain funding or liquidate
assets in order to cover cash flow needs. Liquidity risk can be segregated into:

r Asset liquidity risk: the risk of loss arising from an inability to sell or pledge assets at, or
near, carrying value in order to generate cash to meet liabilities/payments coming due.

r Funding liquidity risk: the risk of loss arising from an inability to obtain rollover financing
or incremental unsecured funding to meet other liabilities/payments coming due.

r Joint asset/funding liquidity risk: the risk of loss arising from a cash spiral, where an inability
to obtain funding leads to forced asset sales/pledges at below-market prices, leading to further
funding shortfalls, and so forth.
Operational risk is the risk of loss arising from the failure of operating procedures, technologies, or processes. Though the class of operating risks is very broad, some of the most
3
It is worth noting that an extreme stage of financial distress, short of default, can create losses in the traded liabilities of a firm;
under our taxonomy of risks, this type of loss is captured as a market-based spread risk loss.
4
Liquidity risk is often included as a subset of market risk. However, for purposes of clarity, we prefer to consider the exposure
on a standalone basis.